Tax-driven mergers: Inverse logic; The rush of firms fleeing America for tax reasons is set to continue

AMERICA is a land of immigrants, but some of its biggest companies are keen to emigrate, driven abroad by high tax rates and America’s “worldwide” system of taxation, which grabs a share of their foreign profits. The preferred method of exit is the “tax inversion”, which uses a cross-border merger—generally one that also has some sort of industrial logic—as the pretext for reincorporating in a more tax-friendly place. Medtronic, a maker of medical devices, is the latest and largest firm to change its nationality in this way.

The combined group will be domiciled in low-tax Ireland, the official home of its merger partner, Covidien (see article). But Medtronic’s executives will stay in Minneapolis and Covidien’s will remain in Mansfield, Massachusetts. Covidien, then part of Tyco, left America for Bermuda in 1997 before moving to the Emerald Isle in 2009. The deal thus involves an inversion with a “foreign” firm that has itself already inverted: a sort of “inversion squared”.

This will be the 15th transaction of the latest inversion wave, which began two years ago. Such deals are particularly popular with health-care and energy firms: Pfizer’s recent, abortive bid for AstraZeneca, which may yet be revived, would have been a blockbuster of the genre. According to Bloomberg, an information provider, close to 50 American companies have flown the coop since tax planners hatched the idea in the 1990s.

Medtronic’s planned inversion is less about reducing the percentage of profits that it pays in corporation tax—which will be only slightly lower after the union—than freeing up some of the $20 billion of foreign earnings that the firm is loth to bring home because Uncle Sam would grab 35% of it. Medtronic has borrowed heavily at home (rather than repatriate foreign earnings and trigger extra tax payments) to finance share buy-backs and dividends. With this deal it can use its foreign cash both to reduce its debt and to finance the acquisition itself, engaging in “hopscotch” transactions that funnel cash from non-American subsidiaries to the Irish holding company, missing out the American layers, says Edward Kleinbard of the University of Southern California.

Wall Street analysts applaud this sort of intra-group shuffling, as it makes capital deployment more “flexible”, typically boosting the share price. Another advantage is that in future the group’s American arms will be able to issue debt, use the proceeds to pay dividends and take an interest deduction that is not taxable in America under its tax treaty with Ireland.

America has tried several times to stop companies fleeing abroad through tax inversion, with limited success. Rules introduced a decade ago required the foreign partner to be worth at least 20% of the combined group. That helped stem the outflow of firms inverting with shell companies in tax-free Bermuda and the Cayman Islands. But it left American multinationals with various options for mergers with smaller firms based in places with low corporate taxes, such as Ireland, the Netherlands and Britain, as long as the target firms had some employees and offices (“substance”, in tax-speak) in those countries.

Bills introduced in Congress this year by Democrats have proposed raising the 20% threshold to 50%; in other words, the foreign partner would have to be as big as the American one for the inversion to stand. The change would be applied retroactively, from May this year.

Were the bills to pass, this latest deal would be blocked, as Covidien investors will own just 30% of the new entity. This is unlikely, since the bills will not win the Republican votes they need unless they are part of a broader tax reform. Still, inverting companies are taking no chances. Medtronic’s agreement with Covidien gives it the right to cancel the deal if Congress rewrites tax laws in a way that deems the merged group an American taxpayer.

There will be more reincorporations, regardless of what happens in Washington. A group of Walgreen shareholders is pushing the drugstore chain to redomicile in Switzerland, for instance. InterContinental Hotels of Britain is reportedly being stalked by an American bidder seeking to invert. Companies have grown more creative in getting around new rules—for instance, structuring deals as private buy-outs to dodge curbs on inversions carried out by means of a public offering.

Tax lawyers already have wheezes up their sleeves in case the Democrats’ 50% rule does pass. An American firm can keep its stake below half, even if its partner is smaller, by taking a chunk of cash in return for the reduced stake—as Mondelez International is doing in a tie-up of its coffee division with Douwe Egberts, a Dutch rival.

Lawmakers are likely to find that simply trying to prevent inversions just leads to more cat-and-mouse games with corporate tax-planners. It would be better to reduce the incentive to leave America by cutting its corporate tax rate to around 25% (partially paid for by hacking away the current thicket of corporate allowances) and moving to a “territorial” system that taxes only domestic profits, as most other countries do. Among other benefits, this would encourage American firms to bring home their foreign profits to invest them in America. Until then, inversions will remain on boards’ agendas. With so much at stake—each percentage-point cut in Medtronic’s tax bill adds $60m to its bottom line—the temptation is simply too great.

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About bambooinnovatorKB Kee is the Managing Editor of the Moat Report Asia (www.moatreport.com), a research service focused exclusively on highlighting undervalued wide-moat businesses in Asia; subscribers from North America, Europe, the Oceania and Asia include professional value investors with over $20 billion in asset under management in equities, some of the world’s biggest secretive global hedge fund giants, and savvy private individual investors who are lifelong learners in the art of value investing.
KB has been rooted in the principles of value investing for over a decade as an analyst in Asian capital markets. He was head of research and fund manager at a Singapore-based value investment firm. As a member of the investment committee, he helped the firm’s Asia-focused equity funds significantly outperform the benchmark index. He was previously the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. KB has trained CEOs, entrepreneurs, CFOs, management executives in business strategy, value investing, macroeconomic and industry trends, and detecting accounting frauds in Singapore, HK and China. KB was a faculty (accounting) at SMU teaching accounting courses. KB is currently the Chief Investment Officer at an ASX-listed investment holdings company since September 2015, helping to manage the listed Asian equities investments in the Hidden Champions Fund.
Disclaimer: This article is for discussion purposes only and does not constitute an offer, recommendation or solicitation to buy or sell any investments, securities, futures or options. All articles in the website reflect the personal opinions of the writer.

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